Almost every kind of investment you make comes with a certain level of risk. For an investment to be viable, the potential return must outweigh the risk. These metrics underline all investments, from the simplest to the most sophisticated. The Sharpe Ratio is a useful tool for making such an analysis before investing.
Let’s delve into how this mechanism can make your risk management calculations more efficient.
What is the Sharpe Ratio?
The Sharpe Ratio is a measure of how much excess returns you will get for the extra volatility you endure in holding a risky asset. In professional terms, it is a metric that gauges the returns from a portfolio after factoring in risk. The Sharpe Ratio will be higher if the investor decides to take on more risks for better rewards and lower if the investor is more risk-avoidant.
From the definition of Sharpe Ratio, it is evident that the element of risk is at the core of this metric. As such, you can use the Sharpe Ratio to evaluate the risk-adjusted performance of a cryptocurrency portfolio.
Regarding investing in conventional markets, options such as government treasuries and bonds from stable economies like the US or Switzerland are considered nearly risk-free. The 90-day US Treasury bill is said to be risk-free. You can easily classify these as “no-risk assets.” Assets classified as risk-free are intuitively said to have a Sharpe Ratio of zero.
However, investments like mutual and index funds come with a certain amount of risk. Investors want this extra risk to have the potential to produce extra returns in comparison to “no-risk assets.” The Sharpe Ratio calculates how much extra returns you will get for incurring the extra risk. The higher the Sharpe Ratio, the better the return-yielding capacity of a fund for every additional unit of risk taken.
William Sharpe introduced the Sharpe Ratio in 1966. Over the decades, it has become one of the most referenced return measures in finance, owing to its simplicity. Notably, Sharpe won a Nobel Memorial Prize in Economic Sciences in 1990 for his work on the capital asset pricing model (CAPM). William is a professor of finance and emeritus at Stanford University.
How to Calculate the Sharpe Ratio
It is important to keep in mind that the Sharpe Ratio is concerned with “excess returns.” You essentially subtract the risk-free return from the portfolio return to get the projected excess return. In a nutshell, the Sharpe Ratio formula involves subtracting the risk-free return rate from the average fund return and then dividing it by the standard deviation of the portfolio return.
Sharpe Ratio formula
The Sharpe Ratio formula is as follows:
Sharpe Ratio = (The expected return of an asset or portfolio – risk-free rate return) / The standard deviation of the portfolio return
In statistics, standard deviation refers to the degree to which the members of a group differ from the mean value of the group. The deviation from the mean value shows the spread in returns from the average return. In this case, the excess return is divided by the standard deviation of returns from the risk of a portfolio. This, in a nutshell, is the Sharpe Ratio formula.
What is a Good Sharpe Ratio?
The Sharpe Ratio is important in analyzing the viability of investing in a crypto fund. So, what is a good Sharpe Ratio? A high Sharpe Ratio shows that the portfolio is making better investment decisions and justifying the risk that comes along with them.
A negative Sharpe Ratio is not good, as it indicates that the risk outweighs the potential benefits of a portfolio because the return of a risk-free rate is greater than that of the portfolio in question.
Here is a breakdown of how to interpret Sharpe Ratio analysis results:
<1: Not Good
1 – 1.99: Okay
2 – 2.99: Really Good
When the Sharpe Ratio is less than 1 or even negative, the portfolio is most likely not a viable investment. On the other hand, a portfolio with a ratio of more than 2 is great for investment. The latter is an example of an investment portfolio that suffers minimal effects from the risk incurred as the fund matures.
Investors are better off with a higher Sharpe Ratio portfolio. A higher Sharpe Ratio is an indication of favorable investment opportunity at the same level of risk. Let’s look at a practical example of how to arrive at a Sharpe Ratio figure.
Suppose you have invested $450,000 in a crypto fund. The fund has an expected return of 12% and a volatility of 10%. An efficient return from the portfolio is 17%, with a volatility of 12%, while the risk-free rate is 5%. All the figures are hypothetical.
Sharpe Ratio = (expected return- risk-free return) / standard deviation of the portfolio
The result is not a good Sharpe Ratio. However, if the expected portfolio return is 35%, the sum will work out as follows:
The second example gives a great Sharpe Ratio. In this way, investors can use the Sharpe Ratio to ascertain their earning potential when investing in a portfolio. The ability to manage risk when investing is why Sharpe Ratio has become very popular in financial circles. For investors, a Sharpe Ratio of over 3 indicates a comfortable investment. The bottom line is that the return should justify the volatility and risk at hand.
During the roaring crypto bull run in 2017, there were some cryptocurrencies that had incredible Sharpe Ratios. John Young, the founder of cryptosheets.com, made some calculations and found that Bitcoin had a Sharpe Ratio of 4 and Dash 3.2.
Such ratios are stunning in any market. A Sharpe Ratio of the past is an ex-post (backward-looking to evaluate past performance) Sharpe Ratio. A Sharpe Ratio that shows the expected future performance of a portfolio is an ex-ante (expected) Sharpe Ratio.
Using the Sharpe Ratio
From the descriptions above, investors can use the Sharpe Ratio to assess various types of funds on offer. Therefore, performing a Sharpe Ratio analysis on a crypto portfolio can be an efficient way to go about picking which funds to invest in.
The Sharpe Ratio determines the risk-adjusted return for a fund, which can be helpful when comparing two funds. For instance, an investment manager X can generate a higher return than another manger Y over a specific period of time. On the surface, X appears to be the better performer. However, if X takes a larger risk than Y, you might find that Y has a better risk-adjusted return.
Cryptocurrencies are obviously quite volatile. Even though major coins like Bitcoin enjoy relative stability compared to the rest, this market is still a rollercoaster. To enter this market is to assume a heightened level of risk by default.
That being said, the crypto market is now diverse and sophisticated. Day trading makes it an interesting field, and this has attracted many more traders than there would ordinarily be. In the context of the Sharpe Ratio, crypto can be either quite volatile or actually quite sedentary, depending on the timeframe you use. For example, a daily Sharpe Ratio will show a different return from the monthly Sharpe Ratio.
Sharpe Ratio with Mutual Funds
Crypto mutual funds are professionally managed investment funds that pool investors’ money to invest in certain assets. There are various types of mutual funds that pool investor funds, whether institutional or retail, to create unique portfolios.
An example is an exchange-traded fund (ETF), which is a fund investors can trade listed on an exchange. You can use the Sharpe Ratio in the performance calculation of crypto ETFs. The approval of Bitcoin ETFs by regulators is one of the most anticipated events in the timeline of cryptocurrency.
Mutual funds aim to maximize professional expertise and investors’ liquidity to come up with diversified portfolios that yield returns for individual investors. Investors are always looking for the best returns while minimizing risk. Hedge funds, while technically not mutual funds, also provide such a portfolio for high-net-worth investors. Sharpe Ratio hedge fund comparison can be valuable in picking out the right one.
When it comes to crypto mutual funds, various factors play into the profitability and risk-adjusted return. The assets that make up a mutual fund vary from fund to fund. Management fees also come into play, but their effect is typically not a decisive factor.
A Sharpe Ratio analysis of a mutual fund can provide valuable feedback. Since it serves as a simple tool for quantitative analysis of performance, it provides a powerful basis for settling on a particular mutual fund. Using the Sharpe Ratio, once can assess the degree of risk that two funds face earning extra returns over the risk-free rate.
Moreover, it can provide objective distinction even between funds that use different strategies, like growth or value or blend. Therefore, you can use Sharpe Ratio to identify whether to add a new fund to your investment portfolio. For example, suppose your current portfolio has a daily Sharpe Ratio of 1.5. Adding a fund with a Sharpe Ratio of 1.75 increases the overall return with lower risk.
Such quick analyses can be an asset in your crypto trading journey. This ratio can allow investors to add better-performing funds to their portfolio. In the rough waters of crypto trading, this helpful metric can help stabilize your boat against the high waves of risk.
Notably, the Sharpe Ratio, like any other statistical measure, involves assumptions and does not take into account extreme market swings. The Sharpe Ratio offers a simplified way to calculate risk-adjusted returns and may not always account for all market developments. Still, it is great for providing a general overview of how a certain portfolio performs. As a rule of thumb, a Sharpe Ratio of over 1 is good enough, while a negative Sharpe Ratio indicates more uncertainty.
Trade using the Sharpe Ratio on Xena Exchange
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